Arnell Industries has $40 million in permanent debt outstanding. The firm will p

Question

Arnell Industries has $40 million in permanent debt outstanding. The firm will pay interest only on this debt. Arnell's marginal tax rate is expected to be 40% for the foreseeable future. a. Suppose Arnell pays interest of 8% per year on its debt. What is its annual interest tax shield? b. What is the present value of the interest tax shield, assuming its risk is the same as the loan? c. Suppose instead the interest rate on the debt were 11%. What is the present value of the interest tax shield in this case?

Explanation / Answer

Debt = $40,000,000

Interest on debt = 40,000,000 * 8/100 = 3,200,000

Tax shield = 3,200,000 * Tax rate

TAx Shield = 3,200,000 * 40/100 = 1,280,000

b. Present value = 1,280,000 * PVF(8%,1)

   Present value = 1,280,000 * 0.926 = 1,185,280

c. Interest on debt = 11%

Interest expense = 40,000,000 * 11/100 = 4,400,000

Tax shield = 4,400,000 * 40/100 = 1,760,000

Present value of the tax shield = 1,760,000 * 0.901 = 1,585,760

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